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Money and Exchange

The importance of money

Money is anything that can be used as a means of exchange between people. Note and coins are the most obvious examples of money. In Roman times, people used blocks of salt to facilitate the exchange of goods and services — that is, a person would be paid in blocks of salt, and then use the blocks of salt to purchase other goods and services, much in the same way that we use notes and coins today.

A system of barter is where goods and services are exchanged directly, without the intermediary of a means of exchange. For example, I might exchange my pig for your coffee table. This is direct barter. Obviously, whilst this is a system that has worked in the past, and is a system to which people revert when the monetary system breaks down (for instance, as a result of a devastating war), money speeds up transactions. Barter is cumbersome and can only work if the two parties wish to exchange goods and services there and then. For instance, I may want to exchange my pig for something, but I will not exchange it unless someone else has a good or service that I value equally in return. Thus a system of barter requires a double coincidence of wants. Clearly, money facilitates the exchange and speeds it up. Hence, the importance of money.

The functions of money

Whilst money is obviously a means of exchange, it has other functions. The functions of money are as follows.

1		A medium of exchange>br>This has already been illustrated by the above example

2		A store of value Suppose I exchange my pig for $300 and deposit the $300 in the bank. I thus defer my spending of the $300 to later. Thus, money acts as a means by which I can store the value of the pig that I have sold, and defer my consumption or use of that value to later. Since money acts as a store of value, it permits the “accumulation of capital”. In other words, people can save the product of their labours and accumulate the power to purchase goods. This enables the formation of capital to take place, and facilitates the development of a modern capitalist economy.

3		A unit of account The prices we pay for different items act as a means by which we can compare their values. For example, I may be able to sell my pig for $300 and buy a table worth $150. By this means the pig is deemed to be worth two tables.

4		A standard for deferred payment It is possible to buy on credit. This means, for example, that I may be able to purchase at goat for $200, but the seller may agree to receive the $200 in one years time. I buy the goat on credit. This works because the seller expects the $200 to retain its value in the future. Perhaps he could only sell the goat for $100 on the day for cash, but he deems that $200 in one year's time is worth more than $100 now, and he also judges that he can wait a year for the money. In this way, money acts as a means whereby deferred payments can occur.

Inflation and hyperinflation

The prices of goods fluctuate. For example, if I take my pig to the market on Monday I may get $300 for it; but if I take it there on Wednesday, I may get $350. The prices of goods are determined by markets (in a market economy) and the means by which these prices are arrived at is through the price mechanism, which is studied in another chapter. However, clearly, the more people that want a pig on a given day, then the higher the price the pig will fetch at the market. So prices are influenced by the demand. Likewise, the more farmers that bring pigs to the market, then the lower the price of an individual pig — so prices are affected by supply.

Apart from fluctuations caused by changes in demand and supply, there are also general changes in prices. Inflation occurs when the prices of all goods and services generally rise. Inflation is defined as a persistent rise in the general price level.

Inflation can destroy the ability of money to perform its functions. For example, if there is inflation, then the ability of money to store value may be affected — people may not know how much $1 will be worth in a year's time. However, mild inflation is not a problem — as we can see from our daily experience. We have methods of ensuring that inflation does not destroy the functions of money — banks give interest on deposits, and these are usually greater than the inflation rate, so the value of one's money can still be stored.

Hyperinflation is the term used for general price rises that are extreme and unpredictable. Hyperinflation occurred in Germany in 1923, when notes with values up to 1 million marks or more had to be issued. When there is hyperinflation the functions of money can break down; in this case, people have to revert to barter.

Forms of money

It is not necessary at this level to be familiar with certain technical definitions of money used, for example, by Central Banks. However, since money's primary function is to act as a medium of exchange, anything which can be exchanged can be regarded as money. For example, instead of paying $300 in cash for a cow, I may write a check for the same amount. Thus, my deposits at a bank are also money. So the student must be aware that money is not confined just to notes and coins, and, indeed, the value of all the notes and coins in circulation is just a very small part of the total amount of money in any economy — since the bank deposits and other forms of money are much larger in total value.